For a long time during the current rate cycle, the continued expectation of rising betas was akin to the “Boy Who Cried Wolf.” While there are a multitude of reasons that resulted in lower betas for longer than anticipated this cycle — from a slower pace of hikes to a more muted overall growth rate in the economy — the most recent quarterly results from banks indicated an intensified environment for deposits. As a result, deposit costs are jumping. Less noticed, however, is that these increases, relative to peers, are starting to have a negative impact on shareholder performance.
To better control deposit costs without sacrificing asset growth or shareholder returns, banks need to evolve beyond methods used in prior rate cycles.
As banks started to report second quarter earnings this summer, the quarter-over-quarter change in both interest-bearing and total deposit costs were markedly higher than in previous periods. While it is true that the current through-cycle beta is still very low — 24% for interest-bearing deposits (IBD) and 18% for total deposits — the incremental beta for IBD in the second quarter was approximately 50% and total deposits neared 35%. That is much closer to the previous cycle and raises concerns about increasing risk of incremental hikes being neutral to NIM.
Novantas created a deposit quality score based on regulatory filings, separating banks into percentiles based on their scores. From the start of July until the banks started to report second-quarter results later that month, there was little differentiation in price performance. Once banks started reporting in mid-July, however, those institutions in the best scoring basket outperformed banks in the worst scoring basket by 7.3% through the end of August.
Additionally, management teams and investors seem more focused on the issue now that it has finally started to rear its head. This is noticeable in the number of mentions of “beta” on 2Q earnings calls, which averaged approximately four times per call at the nationals and approximately 14 times for the largest regionals! This issue was not exclusive to retail deposits with a number of management teams highlighting increasing earnings credit rates (ECR) as well, which is an area that Novantas believes will start to show acute pressure in the coming quarters.
Pulling back the next layer of the onion, the market sees that not only are interest rates and betas increasing, but the mix of deposits is moving into higher-cost products. At the largest banks, including most super-regionals, the industry saw an average of 2% year-over-year in IBDs versus a 2% decline in non-interest bearing deposits (NIBD). While there was significant volatility in the mix of growth, with some banks reaching a net swing of over 10 percentage points, the trend was largely the same: more than 80% of banks indicated an increase in IBDs at the expense of NIBD growth.
Novantas believes that this trend is only beginning, and the real pain for banks is yet to come as we move through the cycle and the remixing shifts from savings and money market deposit accounts toward CDs. During the previous rate cycle from 2004-2006, CD mix moved from 30% to 36% of total deposits, which represents a 17% CAGR. Today, CDs compromise only 15% of total deposit funding at banks. That said, the industry is already seeing increased signs of CD issuance within specific duration buckets. This comes alongside management teams’ anecdotal color during earnings season about their expectations for increased reliance on CD issuance in the second half of 2018.
Altering the quality of deposit franchises is not an easy task or one that can be completed in a short amount of time without polluting the back book. Without improved pricing capabilities, Novantas expects the gap between the haves and the have-nots to widen as this cycle continues.
This implies that banks are running out of time to improve their deposit quality if they want to appease their shareholders. Not doing so could result in a penalty on the valuation multiple through the remainder of the cycle.
While we are more than ten quarters into the current rate cycle, we are still several hikes away from the Fed’s goal for this cycle, which implies that any penalty on multiple could remain for a while. As we head toward the third-quarter reporting season, it is highly likely that the market will further reward the franchise with the higher quality of deposits.
VP of Industry Analysis, Chicago